Finance for Engineers: Financial Ratios

A handful of ratios can provide quick visibility into any business; financial ratios are early warning indicators.

Corporate accounting and finance is controlled by a large number of laws and consensus documents. You'll hear about things like the Financial Accounting Standards Board and generally accepted accounting practices. Some of the accounting rules make no logical sense. They are the result of tax laws made to encourage or discourage certain practices. Ever wonder why your company has some irritating rules for expense statements? Look to the rules that your company has to follow for accounting purposes.

As engineers, we sometimes think that management folks are the bad guys, or at least bumbling incompetents. However, as engineers progress through the management ranks, their focus changes from products and technologies to a series of questions like "Where does the business stand?" and "Can we actually afford to carry out our plans?"

The ugly business truth is that, even after you've delivered products and services to customers, you might not be paid on time -- or even at all. Seemingly irrelevant things (including delays) add up silently but quickly. Then one day you wake up to discover you're out of cash. When you're short of cash, the likelihood of making bad business decisions explodes. You cut the fat, eliminate the dead wood, right size, and make any number of minor and major decisions that will have a lasting impact on the business.

Business managers are paid to make these decisions, but they live in a decidedly non-engineering environment. How can they prevent unpleasant surprises? They have to rely on financial ratios (or accounting ratios), not just because the business may be so complex that it's the only way to sort through alternatives, but also because ratios are the fodder for investment decisions.

Key financial ratios
A handful of ratios can provide quick visibility into any business. Financial ratios are early warning indicators, especially when presented as time-series data. The trends often speak louder than the point-wise ratio of today. Financial ratios come in all shapes and sizes and can be made quite complex. Your company's finance department almost certainly employs a number of the more complex ratios, but you can quickly get an indication of what's really going on in your business based on some simple ratios.

Some business managers adhere slavishly to financial ratios, but ratios are not magic. That's why executives get the big bucks; they choose from among alternatives that may all be unpalatable. A few common ratios, taken with caution, can provide quite a bit of information about a company's relative performance. Financial ratios are tools. Each type of ratio is used for a specific purpose.

Three fundamental types of ratios encompass most of how businesses are measured: liquidity, activity, and profitability ratios.

Liquidity ratios
Liquidity ratios measure the ability to adequately meet short-term obligations. (Did you notice the weasel word "adequately"?) If you personally had to pay all your bills today, could you do it with what is in your bank account (balance sheet for a business)? The quick ratio gives a snapshot of liquidity.

Current assets generally include cash on hand, cash in checking accounts, liquid securities, inventories, notes receivable due within one year, and accounts receivable. Current liabilities include current notes payable, accounts payable, payroll taxes, income taxes, interest payable, and other accrued expenses.

Let's consider Paul, a consulting FPGA design engineer who is in a cash squeeze. He can't pay his bills on time. The quick ratio helps reveal the cause. (The answer is obvious in this case but may not reveal itself as readily in a more complex case). His current assets include $17,000 in cash, $13,000 in accounts receivable, and $20,000 in FPGAs (stock inventories). We'll ignore inventories for now. Current liabilities include $28,000 in accounts payable and $4,000 in provision for taxes.

The quick ratio of 0.94 shows what's causing Paul's cash problem. His current liabilities exceed his liquid current assets. The goal is to keep the quick ratio higher than 1.1 to ensure that there are more current assets than current liabilities at all times. Paul needs more cash now.

The problem may be that he's not collecting fast enough from his customers. Maybe his inventory level is too high. Without a doubt, he needs more working capital now. The key will be whether Paul's liquidity problem is a temporary challenge or a long-term one.

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@JeffL_2 "misreading certain raios" is on way of stating a major mart of the problem. I'd be a bit more blunt: finance often doesn't understand that "an engineer" isn't fungible. An experienced analog engineer is NOT the same as a junior digital designer. Making that connection is up to management, which is where the buck stops. But it's also important for practicing engineers to understand HOW their employer applies ratios - are engineers viewed as a commodity? If so, plan your exit accordingly.

I'm neither a big fan nor a detractor of off-shoring engineering activities. I recently had a conversation with a semiconductor company that has a "design team" in India. Now those engineers are fine for what they are - junior digital engineers. But, they are developing analog-digital converters for use in systems that are reliant on multi-channel, synchrous sampling within a few pico-seconds. They don't understand WHY the ADCs need to have a sampling clock to drive sampling. In this case, THESE ENGINEERS are interchangable parts. But they shouldn't be interchangable - the parts that they create don't work in many of the systems for which they were designed. This is both an enngineering and management failure.

I once argued (unsuccessfully) that moving a microcontroller design responsibility wholesale to an offshore design team was a strategic mistake. My arguement wasn't based on country of origin, but rather on the experience level of the offshore team that was being built. Offshoring can be a good approach for some companies, but often the decision is driven by financial considerations that turn out to be invalid. I've monitored results from numerous offshore teams (incouding those here in the US for foreigh comanies) and the results are pretty uniformly disappointing. But once the host country team has been dispersed, there's little chance of reconstituting the activity fast enough to remedy the now-failing situation.

Some companies, like SUN, develooped the "you're only emplyed as long as you are on a current project" attitude. I thought it was a fyndamentally flawed approach to managing employees. Sometimes is was used to "gently" mget rid of an employee who was no longer wanted. But it also had a terrible impact on engineers' attitude as projects started getting close to completion. The last several monthys of a project tended to have the lions' share of schedule misses as employees were busy looking for another "job" inside the company.

It's management's job, and perhaps their most important job, to find the most valuable employees and make certain that they are used to best advantage over the long haul. It's also theur job to termiate employees humanely when the employee's skills no longer fit the company's mission.

Henry, you know an argument can be made that most of the grief that engineers are currently going through is due to what I might term the "misreading" of certain ratios. Engineers are certainly the largest percentage of the more highly compensated portion of a company's workforce that is also "mobile" (read: used to getting fired regularly, unlike upper management). The ratio of an individual US engineer's salary to that of his Asian counterpart is also high, with the correlation that replacing a US engineer with an Asian one will result in a saving that propagates to the bottom line very quickly. There is also the premise that the expense of employing any particular engineer needs to be charged directly to the project that he is working on RIGHT NOW (perhaps even to the extent of "debiting" his entire annual compensation against a project that lasts only a few months), resulting in a situation that it becomes next to impossible to justify keeping ANYONE "on staff" any longer than the project he is working on lasts, even if it did take a decade or more to acquire the expertise necessary to do the work required, whereas the manager who supervises his work is probably budgeted against a much longer timeframe. Add to this the tendency of many accounting systems to reflect only costs and totally ignore value (like the term "spreadsheet management" that I used in an earlier blog) and I would make the following point: it's not that engineers aren't comfortable or familiar with the use of simple ratios to manage the businesses they work in, it's really that they're so used to being on the wrong end of ALL these ratios that affect their longevity in a negative way that they're really loath to hear much more about them, it can only be more bad news that they don't want to hear!

My version of reality is WAY better than your version -- in my version I'm a superstar and everybody loves me and there's always hot bacon and cold beer close to hand .... I'm sorry, what were we talking about?

Yeah I have an idea. Put an engineer in charge of finance. They understand numbers much better, and actually understand that profit takes time. And a whole bunch of other stuff about math that a finance major couldn't possibly understand. Like the ability to think about more than profit.

In the yUK, TAX rules amount to over 11500 pages, VAT more than 800, the all that EU rules stuff. Not checked to see if it's less or more now (10 years but greater is a distinct probability), no interest in that BS whatsoever!

Cash flow is King to any company. I was never motivated in accounts any less than 3 to 6 months apart. Guess what happens?

Maths, physics, chemistry and electronics. GOOD fun stuff.

A day job and others doing the S&M and beans would be great right now!

@Max The Magnificent Squeeky clean huh? I'd say that you demonstarte a fine sense of what battles are a loosing proposition from the start. I know one fellow who is a multi-millionair several toems over. He's been in na never-ending series of tax disputes for more than 15 years. He's spent MORE on his legal cases than he would have spent had he simply paid ...

In my version of reality, management/finance and engineering are two different worlds. Being in the engineering side, my impression is that management can't seem to grasp reality, all too often.

The recurring example is related to obsessing over just those ratios.

If there's a job to be done, which usually entails something not quite trivial, and something that needs to be completed in a timely manner, engineering has to get going on it. Management likes to stall the effort until they have their dollars all lined up, which makes sense from their perspective as far as that goes. But then, when they finally give the go-ahead to engineering, they expect engineering to rush the work through by some ridiculous deadline. There has to be a better way. There has to be a way of making funds available early, so the work can be done correctly, getting people to work on it as soon as their schedule permits.

I've been at this for decades. It's no surprise at all to me that so many programs seem sluggish and ponderous. Engineering has to find ways to sidestep management, or programs end up being just that. Sluggish, ponderous, unresponsive.